Almost everyone knows about the active secondary market for residential mortgage paper. By contrast, I work in the limited and little-known, but potentially rich, niche of commercial property paper. In the $100,000 to $300,000 bracket, the field is wide open.
Why commercial paper is a thin market
In the residential market, underwriting is fairly routine and only a comparable-sales appraisal is needed. With commercial income-producing property, a comparable-sales appraisal gives investors no assurance of value, and no assurance that the income (which the property’s value is actually based on) will hold steady for the life of the note.
As a result, far less commercial paper is created, and the market has been limited to local investors who can visit the property. The few national investors interested in commercial paper will buy only full notes, with no partials or split balloons, and they require fairly high yields.
Before you criticize those yields, remember one of the first rules of investing: yield is a function of risk. Even with the income approach to value, investors get only an “instant snapshot” of the situation. Nothing guarantees that the property’s management will keep producing enough income over the debt service for the life of the note.
Documents that make a commercial note marketable
Where others saw only problems, my company saw opportunity and developed investors for commercial income property notes. Our investors are usually flexible enough to buy partials and split balloons, or to find other ways to meet a note seller’s needs.
To do that, our investors need to stay informed about the income the collateral property produces. So we make it the job of the real estate broker representing the seller to make sure the note taken back is marketable. We require documentation that includes:
- A requirement that the buyer furnish operating data quarterly to any note holder for the life of the note.
- A specific promise, whose violation triggers default, that debt coverage will not fall below 125%, 135% or some other negotiated ratio.
With these in place, a note holder sleeps better, knowing there will be advance warning of changes that could affect the note’s income stream. Because they can monitor the collateral, our investors can be more flexible about note holders’ needs and comfortable enough to ease their yield requirements.
Answering the buyer who won’t agree
Some of my commercial real estate broker friends say certain buyers would never agree to sign notes with these conditions. My answer is that such buyers are not bankable. If they were, their bank would probably be even tougher, requiring monthly operating data, frequent debt-to-equity ratios, and balance sheets and cash flow statements on the buying entity and all its partners.
Of course, the documentation has to be in place before the seller decides to sell all or part of the note. If the deal is already done and you go back to the buyer for information that would help an investor, you will probably be refused.
Your only hope then is a concession that motivates the buyer: a reduction of principal, a lower interest rate, a longer amortization or some other giveaway. Even so, your seller would probably be better off than holding a note that can’t be sold, or one with a low yield.
Even with this approach, it’s unlikely that the institutions active in the secondary market will become players here. The underwriting guidelines are very different from those used for residential paper. Assessing this kind of paper takes far more analytical knowledge of real estate, and I don’t think institutions are willing to pay for that knowledge, given how little of this paper exists compared with residential.
Why brokers should plan for a note sale from day one
My first article on this subject prompted several questions and comments from the commercial brokerage community, so here are a few more thoughts on seller-carried notes on commercial income-producing properties.
To recap, we structure the documents so our investors can sleep well. We keep them informed, on a continuing basis, about how the collateral property performs, by requiring at least quarterly operating data and a commitment to keep a debt coverage ratio of about 130% or more.
When I talk with commercial brokers, I often hear something like this: “My seller expects to hold the note to maturity, and he wants me to spend my effort improving the terms of sale, not the wording of the documents.”
My response is that, as part of their duty to their clients, brokers should provide for the unexpected. The one thing we can count on is that change comes when we don’t expect it, and we should protect clients any way we can.
Clients will feel doubly grateful to their broker when they need to raise cash from their note. Maybe only then will they realize the note was structured to appeal to investors all across the country, not just to local people who can visit the property and judge its management.
They will also find that the operating data they have been receiving is what sparks interest in their note from investors over a wide area. Because investors can monitor the property’s performance, they are often willing to buy partials, fractionals, split balloons, reverse partials and the like. Until now, a note holder was lucky to interest an out-of-town investor in a full purchase.
Here is an example of how things change. We recently had a note seller who sold a strip center a year or so earlier. Then he decided to come out of retirement and do it again. He is pulling enough cash out of his note to buy a suitable tract for his new development.
The liability risk of an unmarketable note
Beyond giving your client a service he may only appreciate later, there’s another reason to go the extra mile. A few years ago, a California law firm combed courthouse records and wrote to buyers of real property. The letters asked whether the same real estate firm had represented both the seller and the buyer, and whether the buyer felt they had received the representation they deserved. The letter went on: “Come in and discuss your situation. No fee or expense if no recovery.”
Picture this hair-raising scenario. Your seller, holding a standard note form, later decides to pull some cash out of a well-performing note. He finds no takers at what he considers a fair price, and no takers at all outside the local community. Enter a plaintiff’s attorney. Guess who becomes the note holder’s source for the cash he needs.
In short, commercial brokers need to stay aware of the many changes in our industry, such as the newer definitions of agency. The best way to protect ourselves and our licenses is to go the extra mile in service to our clients. Unforeseen consequences can arise even from the most routine parts of our work.
